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“Market Risk, How do Mutual Fund Help An Investor to Manage that Risk”


Sr. No. Particulars Pg. No.

1. Executive Summary. 3

2. Market Risk. 4

3. Common Market Risk. 6

4. How can one Manage Risk. 10

How Does Mutual Fund Help
5. 11
In Managing The Risk.
6. Concept of Mutual Fund. 13
Managing the risk by
7. diversification in terms of Asset 14
8. Asset Allocation Strategies. 20

9. Conclusion. 25
Executive Summary

Each and every stock market in the world goes through the risk associated with the
investments. This project is about mutual funds, how they are managed, the risk and
returns associated with the portfolio, how the assets are allocated and how an investor
should take decision in regards to the assets in his portfolio to minimize risk and increase
the returns.

For any portfolio performance, asset allocation is most important factor which is a
systematic division and risk management of investment among various asset classes such as
fixed income or equities. Asset allocation helps in determining the return on the asset, and
of which major part depends on the variation of the securities owned in the portfolio. For
maximum return and minimum risk from any portfolio one needs to use a proper asset
allocation, and not to rely fully on the financial papers, magazines.

The main purpose for asset allocation is to bring out maximum profit for an
investor. An asset allocation is considered through different strategies. For every investor it
is very important to understand the market, different stocks in which he is going to invest
and the risks and returns associated with these stocks. Each and every investment carries
returns and also certain risks. It is on the investor how he uses different strategies of asset
allocation in his portfolio. This project is all about how to manage the risk associated with
the portfolio with the mutual fund.


Market Risk: What You Don’t Know Can Hurt You

When the Chinese stock market dropped by 9% during a single day in late February
2007, markets around the world quickly felt the impact. In the U.S., the Dow Jones Industrial
Average fell by 4.3%, its worst decline since the aftermath of the September 11, 2001 terrorist

These events underscore how important it is for investors to understand the concept of
market risk, which, like the Chinese stock market example, can result in volatility in one market
impacting other markets. Most investors know that investing involves risks as well as rewards
and that, generally speaking, the higher the risk, the greater the potential reward. While it is
important to consider the risks in the context of a specific investment or asset class, it is equally
critical that investors consider market risk.

Difference Between Business Risk and Market Risk

Risks associated with investing in a particular product, company, or industry sector are called
business or "non-systematic" risks. Common business risks include:

• Management Risk—

Also called company risk, encompasses a wide array of factors than can impact the
value of a specific company. For example, the managers who run the company might
make a bad decision or get embroiled in a scandal, causing a drop in the value of the
company's stocks or bonds. Alternatively, a key competitor might release a better product
or service.

• Credit Risk—
Also called default risk, is the chance that a bond issuer will fail to make interest
payments or to pay back your principal when your bond matures.
By contrast, market risk, sometimes referred to as systematic risk, involves factors that affect the
overall economy or securities markets. It is the risk that an overall market will decline, bringing
down the value of an individual investment in a company regardless of that company's growth,
revenues, earnings, management, and capital structure.

Here's an illustration of the concept of market risk: Let's say you decide to buy a
car. You can buy a brand-new car under full warranty. Or you can buy a used car
with no warranty. Your choice will depend on a variety of factors, like how much
money you want to spend, which features you want, how mechanical you are, and,
of course, your risk tolerance. As you research different vehicles, you'll find that
some makes and models have better performance and repair histories than others.

But whichever car you chose, you will face certain risks on the road which have
nothing to do with the car itself, but which can significantly impact your driving
experience - including the weather, road conditions, even animals crossing the
highway at night. While these factors may be out of your control, being aware of
them can help prepare you to navigate them successfully.
Common Market Risks

Depending on the nature of the investment, relevant market risks may involve international as
well as domestic factors. Key market risks to be aware of include:

• Interest Rate Risk—

It relates to the risk of reduction in the value of a security due to changes in interest
rates. Interest rate changes directly affect bonds - as interest rates rise, the price of a
previously issued bond falls; conversely, when interest rates fall, bond prices increase. The
rationale is that a bond is a promise of a future stream of payments; an investor will offer less
for a bond that pays-out at a rate lower than the rates offered in the current market. The
opposite also is true. An investor will pay a premium for a bond that pays interest at a rate
higher than those offered in the current market.

For instance, a 10-year, Rs.1, 000 bond issued last year at a 4% interest rate is less
valuable today, when the interest rate has gone up to 6%. Conversely, the same bond
would be more valuable today if interest rates had gone down to 2%.

• Inflation Risk—

It is the risk that general increases in prices of goods and services will reduce the
value of money, and likely negatively impact the value of investments.

For instance, let's say the price of a loaf of bread increases fromRs.10 to Rs.20. In
the past, Rs.20 would buy two loaves, but now Rs.20 can buy only one loaf,
resulting in a decline in purchasing power of money.

Inflation reduces the purchasing power of money and therefore has a negative impact on
investments by reducing their value. This risk is also referred to as Purchasing Power Risk.
Inflation and Interest Rate risks are closely related as interest rates generally go up with
inflation. To keep pace with inflation and compensate for loss of purchasing power, lenders
will demand increased interest rates.

However, one should note that inflation can be cyclical. During periods of low inflation, new
bonds will likely offer lower interest rates. During such times, investors looking only at
coupon rates may be attracted to investing in low-grade junk bonds carrying coupon rates
similar to the ones that were offered by ordinary bonds during inflation period. Investors
should be aware that such low-grade bonds, while they may to a certain extent compensate
for the low inflation, bear much higher risks.

• Currency Risk—

It comes into play if money needs to be converted to a different currency to purchase or

sell an investment. In such instances, any change in the exchange rate between that currency
and Indian Rupee can increase or reduce your investment return. These risk usually only
impacts one if one invest in stocks or bonds issued by companies based outside the India or
funds that invest in international securities.

For example, assume the current exchange rate of US dollar to British pound is
$1=£0.53. Let's say we invest $1,000 in a UK stock. This will be converted to the
local currency equal to £530 ($1,000 x £0.53 = £530). Six months later, the dollar
strengthens and the exchange rate changes to $1=£0.65. Assuming that the value of
the investment does not change, converting the original investment of £530 into
dollars will fetch us only $815 (£530/£0.65 = $815). Consequently, while the value
of the stock remains unchanged, a change in the exchange rate has devalued the
original investment of $1,000 to $815. On the other hand, if the dollar were to
weaken, the value of the investment would go up. So if the exchange rate changes to
$1 = £0.43, the original investment of $1,000 would increase to $1,233 (£530/£0.43
= $1,233).

• Liquidity Risk—

It relates to the risk of not being able to buy or sell investments quickly for a price that
tracks the true underlying value of the asset. Sometimes one may not be able to sell the
investment at all - there may be no buyers for it, resulting in the possibility of one’s
investment being worth little to nothing until there is a buyer for it in the market. The risk is
usually higher in over-the-counter markets and small-capitalization stocks. Foreign
investments pose varying liquidity risks as well. The size of foreign markets, the number of
companies listed and hours of trading may be much different from those in the India.
Additionally, certain countries may have restrictions on investments purchased by foreign
nationals or repatriating them. Thus, one may:

(1) have to purchase securities at a premium;

(2) have difficulty selling your securities;

(3) have to sell them at a discount; or

(4) not be able to bring your money back home.

• Sociopolitical Risk—

It involves the impact on the market in response to political and social events such as a
terrorist attack, war, pandemic, or elections. Such events, whether actual or anticipated, affect
investor attitudes toward the market in general, resulting in system-wide fluctuations in stock
prices. Furthermore, some events can lead to wide-scale disruptions of financial markets,
further exposing investments to risks.

• Country Risk—

It is similar to the Sociopolitical Risk described above, but tied to the foreign country in
which investment is made. It could involve, for example, an overhaul of the country's
government, a change in its policies (e.g., economic, health, retirement), social unrest, or war.
Any of these factors can strongly affect investments made in that country. For example, a
country may nationalize an industry or a company may find itself in the middle of a
nationwide labor strike.

• Legal Remedies Risk—

is the risk that if one has a problem with his investment, he may not have adequate legal
means to resolve it. When investing in an international market, one often has to rely on the
legal measures available in that country to resolve problems. These measures may be
different from the ones you may be used to in the India. Further, seeking redress can prove to
be expensive and time-consuming if you are required to hire counsel in another country and
travel internationally.
How Can One Manage Risk?

While one cannot completely avoid market risks, one can take a number of steps to manage and
minimize them.
• Diversify:

As in the case of business risks, market risks can be mitigated to a certain extent by
diversification - not just at the product or sector level, but also in terms of region (domestic
and foreign) and length of holdings (short- and long-term). One can spread his international
risk by diversifying his investment over several different countries or regions.

• Do Homework:
Learn about the forces that can impact your investment. Stay abreast of global economic
trends and developments. If you are considering investing in a particular sector, for example,
aerospace, read about the future of the aerospace industry. If you are thinking about investing
in foreign securities, learn as much as you can about the market history and volatility, socio-
political stability, trading practices, market and regulatory structure, arbitration and
mediation forums, restrictions on international investing and repatriation of investment.
Learn more about the various types of investments options available to you and their risk
levels. Inflation risk can be managed by holding products that provide purchasing power
protection, such as inflation-linked bonds. Interest rate risk can be managed by holding the
instrument to maturity. Alternatively, holding shorter term bonds and CDs provide the
flexibility to take advantage of higher paying instruments if interest rates go up.

Some investments are more volatile and vulnerable to market risks than others. Selecting
investments that are less likely to fluctuate with changes in the market can help minimize
risks to a certain extent.


Let us first understand the concept of mutual fund step by step:

History of the Indian Mutual Fund Industry:

The mutual fund industry in India started in 1963 with the formation of Unit Trust of India, at the
initiative of the Government of India and Reserve Bank the. The history of mutual funds in India
can be broadly divided into four distinct phases

First Phase – 1964-87

Unit Trust of India (UTI) was established on 1963 by an Act of Parliament. It was set up by the
Reserve Bank of India and functioned under the Regulatory and administrative control of the
Reserve Bank of India. In 1978 UTI was de-linked from the RBI and the Industrial Development
Bank of India (IDBI) took over the regulatory and administrative control in place of RBI. The
first scheme launched by UTI was Unit Scheme 1964. At the end of 1988 UTI had Rs.6, 700
crores of assets under management.

Second Phase – 1987-1993 (Entry of Public Sector Funds)

1987 marked the entry of non- UTI, public sector mutual funds set up by public sector banks and
Life Insurance Corporation of India (LIC) and General Insurance Corporation of India (GIC).
SBI Mutual Fund was the first non- UTI Mutual Fund established in June 1987 followed by
Canbank Mutual Fund (Dec 87), Punjab National Bank Mutual Fund (Aug 89), Indian Bank
Mutual Fund (Nov 89), Bank of India (Jun 90), Bank of Baroda Mutual Fund (Oct 92). LIC
established its mutual fund in June 1989 while GIC had set up its mutual fund in December
At the end of 1993, the mutual fund industry had assets under management of Rs.47, 004 crores.

Third Phase – 1993-2003 (Entry of Private Sector Funds)

With the entry of private sector funds in 1993, a new era started in the Indian mutual fund
industry, giving the Indian investors a wider choice of fund families. Also, 1993 was the year in
which the first Mutual Fund Regulations came into being, under which all mutual funds, except
UTI were to be registered and governed. The erstwhile Kothari Pioneer (now merged with
Franklin Templeton) was the first private sector mutual fund registered in July 1993.
The 1993 SEBI (Mutual Fund) Regulations were substituted by a more comprehensive and
revised Mutual Fund Regulations in 1996. The industry now functions under the SEBI (Mutual
Fund) Regulations 1996.

The number of mutual fund houses went on increasing, with many foreign mutual funds setting
up funds in India and also the industry has witnessed several mergers and acquisitions. As at the
end of January 2003, there were 33 mutual funds with total assets of Rs. 1, 21,805 crores. The
Unit Trust of India with Rs.44, 541 crores of assets under management was way ahead of other
mutual funds.

Fourth Phase – since February 2003

In February 2003, following the repeal of the Unit Trust of India Act 1963 UTI was bifurcated
into two separate entities. One is the Specified Undertaking of the Unit Trust of India with assets
under management of Rs.29, 835 crores as at the end of January 2003, representing broadly, the
assets of US 64 scheme, assured return and certain other schemes. The Specified Undertaking of
Unit Trust of India, functioning under an administrator and under the rules framed by
Government of India and does not come under the purview of the Mutual Fund Regulations.

The second is the UTI Mutual Fund Ltd, sponsored by SBI, PNB, BOB and LIC. It is registered
with SEBI and functions under the Mutual Fund Regulations. With the bifurcation of the
erstwhile UTI which had in March 2000 more than Rs.76, 000 crores of assets under
management and with the setting up of a UTI Mutual Fund, conforming to the SEBI Mutual
Fund Regulations, and with recent mergers taking place among different private sector funds, the
mutual fund industry has entered its current phase of consolidation and growth.

A Mutual Fund is a trust that pools the savings of a number of investors who share a common
financial goal. The money thus collected is then invested in capital market instruments such as
shares, debentures and other securities. The income earned through these investments and the
capital appreciation realized are shared by its unit holders in proportion to the number of units
owned by them. Thus a Mutual Fund is the most suitable investment for the common man as it
offers an opportunity to invest in a diversified, professionally managed basket of securities at a
relatively low cost. The flow chart below describes broadly the working of a mutual fund:


The advantages of investing in a Mutual Fund are:

• Professional Management

• Diversification

• Convenient Administration
• Return Potential

• Low Costs

• Liquidity

• Transparency

• Flexibility

• Choice of schemes

• Tax benefits

• Well regulated

Managing the risk by diversification in terms of Asset Allocation

Strings, woodwinds and brass. Stocks, bonds and cash. What do these very different things
have in common? They are all parts of a whole and when they work together, they perform
the way none could alone. An orchestra without violins wouldn't sound as good. And a
portfolio without stocks just wouldn't offer peak performance.

Asset allocation is important for portfolio performance. And what exactly is asset
allocation? It's a systematic division and risk management of your investment among various
asset classes such as fixed income or equities. By having a portfolio that holds different types
of investments, you help reduce your risk and portfolio volatility.
Markets and asset classes do not move in tandem: What's hot today may be cold
tomorrow. Spreading your investment among different types of asset classes and markets—
stocks and bonds, domestic and foreign markets—lets you position yourself to seize
opportunities as the performance cycle shifts from one market or asset class to another.

Depending on your investment style and goals, your asset allocation will vary. One
should work with his financial advisor to create a personalized asset allocation for his
Asset allocation—not stock or mutual fund selection, not market timing—is generally the most
important factor in determining the return on your investments. In fact, according to research
which earned the Nobel Prize, asset allocation (the types or classes of securities owned)
determines approximately 90% of the return. The remaining 10% of the return is determined by
which particular investments (stock, bond, mutual fund, etc.) you select and when you decide to
buy them.

Consequently, buying a "hot" stock or mutual fund recommended by a financial magazine or

newsletter, a brokerage firm or mutual fund family, an advertisement or any other source can be
downright dangerous. One should note that recommendations in publications may be out-of-date,
having been prepared several months prior to the publication date.

As for market timing—that is, moving in and out of an investment or an investment class in
anticipation of a rise or fall in the market—it’s been proven that the modern market cannot be
timed. Market timing strategies, such as moving your money into stocks when the market is
rising or out of stocks when it’s falling, just do not work.

Asset allocation is the cornerstone of good investing. Each investment must be part of an overall
asset allocation plan. And this plan must not be generic (one-size-fits-all), but rather must be
tailored to your specific needs.

Sound financial advice from a trusted and competent advisor is very important as the investment
world is populated by many "advisors" who either are unqualified or don't have your best
interests at heart.

In a nutshell, following are the basic investment guidelines one should live by:

• Determine your financial profile, based on your time horizon, risk tolerance, goals and
financial situation. For more sophisticated investment analysis, this profile should be
translated into a graph or curve by a computer program.
• Find the right mix of "asset classes" for your portfolio. The asset classes should balance
each other in a way that will give the best return for the degree of risk you are willing to
take. Financial advisors can determine the proper mix of assets for your financial profile.
Over time, the ideal allocation for you will not remain the same; it will change as your
situation changes or in response to changes in market conditions.
• Choose investments from each class, based on performance and costs.


Asset allocation is based on the proven theory that the type or class of security you own is much
more important than the particular security itself. Asset allocation is a way to control risk in your
portfolio. The risk is controlled because the six or seven asset classes in the well-balanced
portfolio will react differently to changes in market